Monday, December 14, 2009

In a recent speech Adam Posen (recently appointed a member of the Bank of England's Monetary Policy Committee) argues that monetary policy should not be used to deal with asset price bubbles. His main argument, which has been expressed before by different central bankers, is that monetary policy is the tool to deal with price stability and it is not appropriate to deal with asset price bubbles. Quoting from his speech:

"Just because we want there to be a policy response to a problem does not mean that the problem can be solved with the tools at hand. Again, if I have a hammer, it can be useful for all sorts of household tasks, but useless for repairing a leaky shower head – in fact, if I take the hammer to the shower head, I will probably make matters worse. I need a wrench to fix a pipe leak, and no amount of wishing will make a hammer a wrench. This is the essential reason why central bankers are now looking around for what has been called a ‘macroprudential instrument’, that is a tool suited to the job – and a tool additional to the one that we already have in our toolkit."

I am very sympathetic to this argument, interest rate is probably not the right tool to deal with asset price bubbles and using regulation or a 'macroprudential instrument' is the right thing to do.

However, we still need to ask the question: What if those instruments are not available or are simply failing to do their job? Is there a role for monetary policy? He cites the example of Spain as a country where the central bank was stressing the importance of dynamic provisioning for banks and still went through a real estate bubble. It might be that the Bank of Spain was not aggressive enough, but how do we know that the systems that we are setting in place now will take care of the next bubble or financial imbalance?

One can argue that interest rates should not be used to deal with an imbalance in financial markets, because this is not part of their mandate, but I think this is a very narrow view of the role of central banks. There is no doubt that imbalances in financial markets spread to the real economy. In fact, there were many signs of a macroeconomic imbalance prior to the crisis such as excessive consumption, current account imbalances. Aren't interest rates the tool to deal with macroeconomic imbalances?

If we apply Adam Posen's logic to some of the previous recessions, we could come up with the conclusion that central banks should never use the interest rate as a stabilizing tool. We could always claim that previous recessions originated in a specific sector of the economy and it would be better to deal with these developments using 'sector-specific' tools. Adam Posen uses as an example a procyclical tax on real estate that might avoid real estate bubbles like the one we just went through. We could apply the same logic to the internet bubble of the 90s and argue that a tax on internet-related companies would have avoided that bubble. This might be true but how do we know where the next bubble will come from so that we set up the right 'procyclical tax' to avoid it? In my view, if the next bubble generates a macroeconomic imbalance, then it is the role of monetary and fiscal policy to deal with it. The next business cycle, the next bubble is likely to be different from the current one and we will learn from it and set up additional policies to make sure that it does not happen again, but until we figure out policies to avoid any potential bubble or imbalance that can cause a recession, monetary policy still has a role to play. And yes, using a hammer to fix a pipe leak will be a challenge...

Thursday, December 10, 2009

Here is an excerpt from an interview by Jean-Claude Trichet, President of the ECB with De Tijd and L'Echo (the full interview can be found at the ECB web site).

Q. For some financial assets, such as gold, we are seeing a return to risk-taking on the part of investors. Is this a parameter that the ECB takes into account in its strategy?

A. I will not make any specific comments regarding gold.

Generally speaking, one of the fundamental lessons of the crisis is that when we underestimate financial risks and focus only on the short term, we set the stage for a future catastrophe. The new principles for bank remuneration, which the international community have agreed within the framework of the Financial Stability Board, were established precisely in order to ensure that there is no incentive for operators and traders in particular to favour the most risky attitudes and decisions, leading to illusory profits in the short term at the expense of the long-term interests of the financial enterprises concerned and the stability of the financial system as a whole.

It is always interesting to see how central bankers tend to start their answers by saying that they will not make any specific comment on a market or an asset price and then make a broad statement about how financial markets need to be careful and not create bubbles. This reminds me of the famous question by Alan Greenspan back in December 1996: "How do we know when irrational exuberance has unduly escalated asset values?" Great question and I would like to know the answer!

Should central banks provide more guidance to help us answer our questions and doubts about asset prices (or other financial market developments)? Should they share their views and forecasts on the evolution of asset prices as they do for other financial variables, such as interest rates? I do not know what the right answer to these question is but I find the current communication style from central banks ("no specific comment on that question but...") unsatisfactory.

Antonio Fatas

I am the Portuguese Council Chaired Professor of European Studies and Professor of Economics at INSEAD, a business school with campuses in Singapore and Fontainebleau (France), a Senior Policy Scholar at the Center for Business and Public Policy at the McDonough School of Business (Georgetown University, USA) and a Research Fellow at the Center for Economic Policy Research (London, UK).